Tax tricks and drawing-down guidance to bolster a battered retirement portfolio
With the volatile financial markets erasing years of carefully built savings as if they were scribbles on a whiteboard, new retirees and those preparing for retirement are cursing their bad timing. But even with stock market values battered and the economic outlook grim, older investors can draw on a number of different strategies to keep their nest eggs from being wiped out.
TAP TAXABLE ACCOUNTS FIRST
A key strategy for making your money last over the long haul is to pull cash out of retirement accounts in the right order. Retirees often make the mistake of raiding their tax-deferred retirement accounts first. That generates higher taxes that can kick off a vicious cycle: Paying those taxes further erodes the value of a portfolio, says James Lange, author of Retire Secure! (Wiley) and a CPA and estate planning attorney in Pittsburgh.
Imagine two 66-year-olds, both in the 15% tax bracket, who each retire with $1.4 million saved, says Lange. The bulk of the money—$1.1 million—sits in tax-deferred retirement accounts earning an 8% annual return. The other $300,000 is in taxable accounts. Both people hope to spend $96,000 a year after paying income taxes (that $96,000 includes a Social Security benefit of $25,750 in the first year, which increases by 3% annually). While this withdrawal rate is higher than what Lange recommends, he uses this example to show why tax-deferred money should be tapped later in retirement.
Retiree No. 1 pulls money from his tax-deferred retirement account first, which triggers income taxes. He pays those taxes by further drawing down his tax-sheltered stash. The first year, about $90,000 is withdrawn from his tax-deferred account before he is even required to tap those savings at age 70 1/2, which results in an income tax hit of $19,300. According to Lange's calculations, the retiree's $1.4 million pot would be depleted by the time he hit age 98.
That might seem a pretty decent run. But consider the fate of the retiree who withdrew money from his $300,000 in taxable accounts first. For someone in his tax bracket, tapping those accounts triggers a capital-gains tax rate of 5%. Some two years shy of the century mark, this retiree will still have $1.4 million.
Bottom line: Most affluent investors should wait to withdraw from traditional IRAs and other retirement accounts until the government requires it—after they reach the age of 70 1/2. And because it is the most valuable of retirement gems—for retirees and for their heirs, who will not have to pay taxes on the money—leave raiding any Roth IRA for last, if at all.
GO FOR TOTAL RETURN
Smart financial planners have long pooh-poohed the wisdom of retirees depending on income-only portfolios. Instead, investment advisers prefer total-return portfolios designed for growth—portfolios of stocks and bonds that provide income but that also offer the opportunity for capital appreciation on stock holdings over time. A retiree skims off the dividends and interest, as well as capital gains, and repeats the exercise each year. Obeying those marching orders, however, can be nerve-wracking. For one thing, steadily selling stocks to reap those gains requires a lot of discipline. And in this manic market, who relishes selling stocks that, even if they do have gains, are being sold at prices that have sunk so low?
Maintaining a two-year cash reserve in a total-return portfolio can help give retirees the courage to keep a respectable amount of their portfolio in stocks, says Lane Jones, chief operating officer at Evensky & Katz Wealth Management in Coral Gables, Fla. With this approach, which the firm has been using since the mid-1980s, retirees write themselves a check each month from the cash account, which contains money market funds or high-quality short-term bond funds. "Strangely enough, there is a behavioral element to this," Jones observes. "If you know the grocery money is set aside and how the bills will be paid in the next couple of years, you have staying power to stick with your investment portfolio in very tough markets." And since many financial advisers have, over the years, been raising the recommended amount that older investors should hold in stocks, that staying power is crucial.
If the cash runs out during a period when stock markets are roiling, the retiree will draw down a bond portfolio composed of short-term and intermediate-term bonds. Using this method, it's unlikely that a retiree would have to tap stocks when they are getting pummeled. If you do have to take a required minimum distribution, and doing so with stock is the only option left, veteran tax accountant Ed Slott of Rockville Centre, N.Y., notes that you can simply move a block of stock intact from the retirement account into a taxable account.
A potentially helpful recent development on the withdrawal front: the passage of a bill, which President Bush is expected to sign, that will allow retirees to skip required minimum distributions in 2009 without being penalized.
INSULATE YOURSELF FROM INFLATION
Inflation is the silent killer of retiree portfolios. But a fixed-income anomaly can help aging investors stretch their buying power. The opportunity comes in Treasury Inflation Protected Securities, or TIPS, which offer investors a fixed interest rate above inflation, as measured by a consumer price index. "TIPS are a screaming buy unless you actually think we're going to have significant deflation," says Larry Swedroe, a St. Louis investment adviser and co-author of The Only Guide to Alternative Investments You'll Ever Need (Bloomberg Press). While acknowledging that there is some deflation risk today, Swedroe believes the greater long-term risk is inflation.
The real, or inflation-adjusted, rate on some TIPS now exceeds the nominal rate on traditional Treasury bonds, which have experienced soaring prices due to a frenzied flight to quality among investors. The best deals right now are older TIPS with longer maturities that you can buy on the secondary market. Recently, for instance, you could have bought a TIP maturing in seven years (January 2016) that provided a yield of 3.16%. In comparison, the yield on a new five-year TIP was 1.24% , and the yield on a nominal five-year Treasury bond was 1.12%, as of Dec. 17.
BECOME A CONVERT TO ROTHS
The market's wreckage has created an opening for retirees to convert a traditional IRA to a Roth IRA, which switches a portfolio from tax-deferred savings to tax-free savings. When you convert, you pay taxes based on your tax bracket. With retirement account values down, it's a good time to make the move.
Individuals or couples whose adjusted gross income does not exceed $100,000 can do a Roth conversion. After they do that, future withdrawals are tax-free—and there's no need to bother with those vexing required minimum distributions.
Many well-to-do retirees have been shut out by the Roth's income-eligibility rules, but this problem is scheduled to disappear in 2010. Then, for the first time, wealthy investors will be able to convert their traditional IRAs into Roth IRAs. It's best to do the conversion during early retirement. That's the period when it is more likely that a person's income has declined but before the age when those mandatory withdrawals kick in—and raise taxable income once again.
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